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Category:
Insurance News /
Life Insurance /
Nedgroup
/ July 2006
Adding a hedge fund sweetener to retirement funds
Excessive media coverage of isolated hedge fund failures has led to
the whole industry of 8000 funds being unfairly tainted with the
same brush, argues Lizelle Steyn, manager of Alternative Investments
at Nedgroup Investments.
 “Hedge
funds are actually innovative investment vehicles and for decades
where the smart money – such as that of the Harvard and Yale pension
funds has flowed. Unfortunately, hedge funds have often also
unfairly become the scapegoat for any unusual market or currency
movements."
"In
1992, for example, the British Pound devalued so much that it
dropped out of the European Currency System. It was initially
believed that this too was caused by hedge funds, but a study
published by the International Monetary Fund showed no evidence of
market manipulation by hedge funds.”
She
says the damaging effect of one hedge fund failure to the reputation
of these funds is often magnified by the myth that all hedge funds
form part of one homogeneous asset class.
In
truth, there is an assortment of strategies behaving very
differently under different market circumstances, all with different
risk profiles and often displaying very low correlation with one
another. Speaking of hedge funds as an asset class would be like
speaking of unit trusts as an asset class.
“Similarly, dictionary entries for hedge funds stating that they
‘offer investors the possibility of extraordinary gains with
above-average risk’ are misleading. The majority of South African
hedge funds are more concerned with capital protection than with
‘shoot the lights out’ returns."
"This
is evident from their benchmarks, which are typically inflation plus
five percent or cash plus three percent. On the other hand, thinking
that all hedge funds offer capital protection is equally dangerous.
Some South African hedge funds in the Trading category aim to
outperform the ALSI 40; such outperformance would require a far more
lenient risk budget.
“Another common myth is that hedge funds are too risky and
inappropriate for retirement funds. Looking at the consistently
positive rolling 12-month performance of the Nedgroup SA Hedge Fund
Index, the low volatility of this index and the small number of
negative months, hedge funds clearly carry much lower market risk
than the three traditional asset classes (equity, bonds and
property)."
"Importantly, these hedge fund returns are for the entire group that
submit monthly data to the Nedgroup Hedge Fund Review. Most
individual underlying hedge fund returns would be more volatile,
which makes investment in a fund of hedge funds preferable.
“Unfortunately, operational risk (particularly fraud and poor
business management) is higher - mainly due to the unregulated
nature of the hedge fund industry. But a multi-manager approach can
reduce the latter risk greatly. Unless pension fund trustees are
very familiar with hedge fund techniques and the risks of the
unregulated environment, the fund would be better off starting out
with a fund of hedge funds, that diversifies across different hedge
fund categories and which is managed by a team skilled in selecting
and monitoring hedge funds.
“Why
would a retirement fund want to invest in hedge funds in the first
place? Early Modern Portfolio Theory, as first theorized by
Markowitz in 1959, even before hedge funds became popular, showed
how holding short positions in a diversified portfolio can further
push out the efficient frontier to the left."
"In
other words they enable higher returns for the same level of risk
(as illustrated by the green curved line in the accompanying graph)
or the same level of returns, but at a lower level of risk. Several
empirical studies, among others the 2000 Harvard study by Elizabeth
Darst, also found that adding hedge funds to a long only balanced
portfolio (for example, the core portfolio prescribed by the pension
fund consultant) significantly increases the efficiency of that
balanced portfolio.
“In
the example of the accompanying graph, the consultant prescribed a
long only asset mix with an expected volatility or risk of 9% and an
expected return of 12% (point L). By adding a hedge fund component
we can keep the risk at 9%, but increase the expected return
slightly (in other words move the total portfolio, including the
hedge fund component, to the point marked H+L)."
"But
not just any hedge fund or fund claiming to be a hedge fund would be
able to offer the sweetener of higher returns at the same level of
risk. The fund should meet all of the following three critieria:
“Retirement fund regulation currently allows retirement funds only a
2.5% allocation to hedge funds – classified as “other”, but this
limit could increase in the near future. Many studies show that a
much higher allocation to hedge funds would be ideal, considering
the risk-return characteristics of these funds."
"But
ultimately, you would rely on your pension fund consultant for an
indication of how much to allocate to these risk-return enhancers.”
Hedge
funds enhance the efficient frontier
Source: ITInews – Insurance
Times and Investments Online
www.itinews.co.za
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